We are beginning to see the distant rumblings of 50bp tightening suprises from "The Street". At one point there was even a near 10% probability priced into the June Fed funds contract. As I noted in a previous post, talk of a "shock 50" was bound to happpen. Such a move, however, is unlikely to occur and unlikely to get the Fed what it wants -- slower growth. Why not? In the first instance, in reaction the long end rallies and so too might the stock market, anticipating that the Fed is done and may soon have to ease. The transparent policy mantra will have everyone priced in and hedged up. A 50bp move collapses the time frame of expectations, not the final outcome.
Of course the market will be 100% wrong because the shock won't end up adversely impacting the economy at all and expectations will soon begin pricing in a string of 50bps tightenings, although not for a long enough amount of time in my opinion. If we have learned anything these past 25 years, though the street seems to have forgotten, it is that the U.S. economy is more interest rate insensitive. The level of real rates required to slow the economy has moved higher. Why? The old regulatory circuit breakers have long been deregulated and financial innovation has allowed everyone to float assets and liabilities.
So there are two issues with a "shock 50". First, market expectations adjust the whole curve rather quickly to fit the new policy and everyone borrowing against the curve adjusts accordingly. Given that the economy floats on both sides of the ledger, the net impact will be small. Second, levels are still way too low to curtail credit expansion. Other things might put a halt to borrowing and lending, but it won't be the cost of money.
Getting back to the adjustment issue, herein lies a fundamental problem with a transparent Fed at this juncture of the business cycle. Gingerly raising interest rates from a near deflationary environment required alot of hand holding, etc. in order to get rates where they needed to be without people losing confidence. The problem now is that If everyone knows whats coming, the markets price it in and businesses hedge it up. At some point, later rather than sooner, Poole will be making a transparent attempt at convincing the world that an opaque policy is the best alternative. How do you do that? Take a page from Volcker -- target reserve growth and let the market price Fed funds.
If you can no longer count on a rational and known path for funds, what then? The impact on the real economy could be negative -- if rates are high enough.
We are far from the need for any of this, which is why 50bp is far from reality. The economy is not in the midst of runaway growth. But I do know this, if you think the well-telegraphed slow but steady policy that has created the trajectory of 25bp moves followed by plateau and then ease, and all within the next 12 months or so, is going to slow growth -- think again.